Water rate increases could be coming soon to Morro Bay residents to cover water costs and to help the city comply with an agreement with its water delivery provider.

The Central Coast Water Authority, which handles the infrastructure and bond issuance related to the city’s state water supply, sent the city a warning letter dated April 8, saying that it was undercharging customers because the charges fail to cover all water costs plus funding for an emergency reserve.

Morro Bay hasn’t increased water rates since the mid-1990s and rates now only cover about 78 percent of the city’s annual $1.125 million payment for state water.

The city hasn’t defaulted on state water payments because it has filled the gap by drawing from its reserve water fund, which could be used for capital improvements to its local system of wells or its desalination plant.

Water authority Executive Director Ray Stokes warned that the shortfall is affecting the water authority’s credit rating outlook and the city is failing to provide enough money for potential emergency and contingency needs.

Rob Livick, the city’s director of public services, said that Morro Bay’s City Council is reviewing five consulting firms that responded to a request for proposal to conduct a rate study.

The study requirements state the proposed rate structure should demonstrate “compliance with the rate covenants” of the outstanding bond. The rate study is expected to cost the city between $38,000 and $70,000, Livick said.

Livick said if a “majority protest is not filed, then the city could have a new water rate in place by the end of 2014 that would comply with the requirements of CCWA.”

The water authority provides infrastructure, including treatment facilities and pipelines to deliver state water to Morro Bay. The warning letter states the city has fallen short of meeting its obligation of covering its bond debt through rates and charges at a ratio of 1.25 since 2009.

That means the revenues the city collects from rates should pay for all of the annual state water costs and then exceed that amount by 25 percent for reserves.

State water typically makes up nearly all of the city’s water supply on an annual basis. Morro Bay is allocated about 1,300 acre-feet of water from the state each year. But this year, the city is receiving only 5 percent of its allocation. The rest is coming from stored water that carried over from past years when the city didn’t use all of its share, Livick said.

According to the water authority, the city water fees cover the debt at a ratio of .78, or about 78 percent of the cost for the water. “We don’t take in enough revenues,” Livick said. “We currently can’t make the entire debt payment just from fees.”

Stokes said the authority doesn’t have any specific timeline for the city to meet its obligation. An arbitration ruling is an option for the county’s Flood Control and Water Conservation District with which the water authority contracts to deliver state water – and the authority may call for arbitration on its own as well in the case of a dispute with the city of Morro Bay under its agreement.

“We know that the city is planning to meet with the county to discuss water,” Stokes said. “We’re going to wait and see what happens with that. …We don’t have any specific plans right now.”

One of the concerns for the water authority is that Moody’s Investors Service included a negative rating outlook “in part because of the city’s continued noncompliance with the coverage ratio.”

Morro Bay makes up about 6 percent of the authority’s bond debt service payments, which include other Central Coast communities in Santa Barbara and San Luis Obispo counties. Moody’s reaffirmed the CCWA’s rating at Aa3 for its bonds. An Aa3 rating is one that Moody’s considers high quality with low credit risk.